Theory suggests profit maximization of shareholders as objective of the firm. Thus, a study of the sources of profits is indispensable in achieving the said objective. However, a study of profit at firm or industry level differs from a study of aggregate profits at an economy level. The economic activity of a country is anchored on the analysis of the macro aggregates. It is imperative to comprehend the associations between profits and macroeconomic activity. Indubitably, there needs to be mathematical model or an identity that links the aggregate profits with the macroeconomic activity.
A firm’s ability to generate profits is linked to its skill set in navigating the minutiae of competition. The most skilful, agile, versatile firm might win the race yet these traits might not have an impact on the total number of prizes available at the aggregate level. In other words, supply elasticity of prizes is independent of the individual characteristics of the firm.
The profit equation was developed first by Jerome Levy in 1908 and later Kalecki also developed the same. While Kalecki got the initial credit, today, the equation is often called Levy-Kalecki equation. The equation is more of an identity. It seeks to explain how economic growth generates through seeking an identification of sources of profits. Further, it posits profits are not a zero sum game. Higher aggregate profits indicate a greater economic activity. It also helps to identify the sources and drivers of the activity and helps in marking the prospective red flags. Thus an analysis if this equation should be germane.
In macroeconomics, accumulated wealth is called savings while created wealth is called investment. The primary identity in a two sector model is savings equalise investment. The firms produce goods and services which are consumed by households. These households get income by providing factor services to the firms. The firms sell goods and earn income which they distribute as factor costs to the households in exchange for factor services. Thus the circular flow of income takes roots. Yet households do not spend all their income on consumption but save through financial intermediaries which is injected back into the economy as investment. Thus
Savings (S) = Investment (I)
Yet the economy is not confined to two sectors in practice but encompasses government sector and the external sector. Therefore investment is financed from host of sources of savings
I= household savings + business savings + government savings + savings from the rest of the world
If household and business savings are constant, government deficits exist, then current account deficit will have to increase to sustain the existing levels of investment thus a prospective cause of twin deficit crisis. That however would be a different story. Without digressing, let us carry forward our analysis.
Business savings occur from business profits deducted of corporate profit tax and dividends paid.
Therefore
I = Shh + (P – Cpt – Dp ) + Sg + Srow
Where Shh is household savings, P represents corporate profits, Cpt represents tax on profits, Dp represents dividends distributed, Sg represents government savings (dissavings if negative) and Srow represents savings of the rest of the world.
Rearranging the above equation, we find
I – Shh + Cp +Dp – Sg – Srow = P
Therefore profits before tax and dividend are essentially a sum of investment, tax on profits, distributed dividend deducted of household savings, government savings and savings of the rest of world.
One can club the household, government and rest of the world savings as non-business savings. Therefore one can plot profits as the sum of investment, profit taxes, dividend payments net of non-business savings
Business profits = Investments – Non-Business Savings + Taxes on Corporate Profits + Distributed Dividends.
When one discusses investment, the asset creation in the economy, it implies gross investment. Yet in the course of time, the use of the asset is expensed through depreciation and when there is breakdown or destruction or loss of an asset, the value is written off. Therefore,
Net investment= gross investment –capital consumption
Where capital consumption is depreciation plus write-offs
In the above equation, the modification would be
Business profits = Net Investment + Capital Consumption – Non-Business Savings + Taxes on Corporate Profits + Distributed Dividends.
While it is an accounting identity thus giving a required equation, its import is significant. For instance, one can have a cursory analysis of the current economic scenario. There is increasing possibility of a price war in oil between Russia and Saudi Arabia. The implications are many, yet for oil importing country like India, there might be positive spill-overs. The trade deficit is positive thanks to the oil imports. Implied is lower oil prices will bring down the trade deficit thus reducing the need to depend on the rest of the world savings to finance our deficit. A reduction in rest of the world savings eases the pressure on government deficits thus a virtuous effect on the non-business savings. This would translate into greater investment thus higher profits at constant levels of profit taxes and distributed dividends. Higher profits in turn create virtuous cycle for fresh investment thus boosting the macroeconomic aggregates like the GDP. Incidentally, the identity posits a budget surplus would constrict demand ceteris paribus. If governments run a surplus, thus a shrinking of their balance sheet, sustaining the same level of profit necessitate an expansion in the balance sheet either of the households through increase in consumption or rest of the world through an increased investment in capital account or through corporate through an increase in net investment.
The Kalecki-Levy equation thus gives an identity that enables the policy makes and firm decision makers a valuable tool to link up the connections between macroeconomic activity and the firm profits. It is also significant yet underutilized tool in decoding the directions of the stock market. Incontestably, as the profit analysts at micro level build their models, they need to check with their macro considerations for which K-L equation gives a building block.
Thoughts on Theory and Practice 